Fact of the Week: A 1 Percentage Point Increase in Local Business Taxes Decreases R&D Spending 7 Percent After 8 Years

Luke Dascoli December 13, 2021
December 13, 2021

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Source: Lichter et al., “Profit Taxation, R&D Spending, and Innovation,” IZA Institute of Labor Economics, November 2021.

Commentary: Given the high social value of scientific innovation, policymakers should stimulate innovative activity from firms. But when higher local taxes reduce the after-tax returns of business investment, firms may become less inclined to invest toward new innovations.

Using a case study from Germany, economists at the IZA Institute of Labor Economics conducted empirical research on the impact that business tax rates imposed on firm R&D funding. While Germany is one of the most R&D-intensive nations in Europe, the country has lacked any kinds of R&D tax incentives for firms during the entire time-horizon of their research (up to January 2020). Further, Germany’s municipalities set their own local business taxes independently, making tax effects on R&D more directly identified.

To isolate long-term impacts that local business tax imposed on German R&D, the researchers’ model observes change in investment with an eight-year time lag. Their econometric findings show that a 1 percentage point increase in the local business tax leads to a 6 to 7 percent decrease in R&D spending after the time lag. Municipalities with lower local business taxes had more R&D-intensive firms that produced more patents than those with higher taxes, showing the long-term consequences.

If policymakers want to continue supporting innovation and the public benefits that innovation brings, then tax rates should be set with the interests of both public revenue and scientific progress in mind.